Trader’s Narrative

Here is a chart plotting every single major rally in the Dow Jones Industrial index since 1900:

Source: Chart of the Day

While the Dow has surpassed its highs from last month, this has not been confirmed by other major indexes. In any case, there have been 27 significant rallies in the past 109 years of market history - not counting the current one. That’s about one for every 4 years. Paul Desmond of Lowry Research pointed out this four year cycle as one of his reasons for believing this to be a real bull market.

About three quarters of the rallies resulted in a gain of 30%-150%, lasting 200-800 trading days (9.5 months to 3.2 years). These are the data points highlighted in the blue shaded box above. The current rally is just shy of making it as it is too short in duration.

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The stock market’s resilience was in good form today as it inched ahead, managing to recover from the shallow pull back of 3 weeks ago. The Dow Jones even managed to put in a new high for the year while the S&P 500 index and the Nasdaq were not far behind. I’m not sure if this shallow pullback is what Lowry had in mind when they cautioned against jumping with both feed into their intermediate buy signal.

The tongue in cheek title of this post is inspired by the classic Kubric film, “Dr. Strangelove“. I thought of it when I looked at today’s chart of the day showing the subsequent returns for the worst yearly returns of the Dow Jones:

Source: Chart of the Day

The 15 largest annual declines in the history of the Dow usually lead to a reversion to the mean. But not always. The 1930’s were as you’d expect, a wild card where bad simply got worse. Of course, back then you didn’t have the Fed opening the liquidity spigots like today. The only other outlier is 1978 which was slightly down during the brutal 1970’s bear market. Not surprisingly, when we step back and get some real perspective, cycles are obvious and we tend to go from bad to better. This is basically what I argued that Why Long Term Investors Should Consider Buying:

Can things get worse? Of course. But at this point, if you have a long term time horizon, a cast iron stomach for risk, the data suggests you should be taking small positions and slowly adding to them cautiously, even if the market continues to tank. That may sound crazy, but where we are right now in market history, only comes about very rarely.

Boy did things get worse. And if you were foolhardy (or smart?) enough to have an unemotional take on the market and a long term view, stepping into the abyss wouldn’t have been all that horrible. You would have been buying into a decline but in 4 short months, it would be all over.

In fact, we’re starting to see signs of real strength in the market. For example, the number of new 52 week highs in the US markets has recovered to pre-crisis levels:

Source: Bloomberg

Usually any measure reaching bear market tops sends shivers down one’s spine but keep in mind that this metric has not reached an extreme level. For example, consider that it was much, much higher towards the end of 2003 or early 2000 (not shown on the above chart). Both extremely unfortunate times to be long the equity markets. Right now however, we’re just seeing some resilience not speculative mania.

Yes, yes, I know the market is pricing in some insane numbers, including ginormous positive GDP growth and totally ignoring unemployment and a half-a-dozen other factors. What you have to remember is that the market does this all the time. In a bear market, it ignores bullish arguments repeatedly - until it doesn’t. And vice versa. So why argue?

Some are comparing the current bear market to the brutal one we saw in the 1930’s, so here’s a chart comparing this rally (so far) to the bear market rallies back then:

Source: Chart of the Day

To be honest, I don’t really like the Dow Jones Index so I’ve plotted the point at which the current rally reached its maximum as measured by the Standard & Poors 500 Index in green - a 37.4% increase from the spring lows (reached on May 8th 2009). Since then, the stock market has just slithered sideways anyway.

Any way you measure it, either by the Dow or the S&P 500, the present rally has been stronger than most of the bear market rallies in the 1930’s. The outlier is the November 1929 rally which lasted 155 days and took the Dow 48% higher.

Last summer I showed the inflation adjusted price of crude oil - below is the updated chart:

Source: Chart of the Day

It really puts last year’s crude oil bubble into proper perspective. Not only was it about 30% more intense than the 1970’s oil shock, it towers over the other price spikes we’ve seen.

What is even more peculiar is that this bubble was entirely artificial. It was not due to any geopolitical rationale, nor was it because of a supply/demand imbalance. It was entirely concocted out of thin air by large traders.

The world economy was fragile because of excess credit and speculation. Oil was the first domino to topple and knock the others down by slowing down the economy to reveal the rot under the surface. If it wasn’t the main cause of the worldwide economic slowdown, it was definitely one of the leading reasons for its severity. Although the connection needs no explanation, you can clearly see that every single recession was either preceded by or coincided with a large increase in the price of oil.

The crazy part of all this is that no sooner had the dance ended that the same players started dancing all over again. Hedge funds and large players are once again stampeding back into crude oil and commodities. After bottoming in February 2009, crude oil has doubled in price! That’s a little over 3 months ago!

And once again, there is absolutely no rationale for such a move. What? Have we suddenly lost our previous reserves of oil? is production somehow curtailed by war? or geopolitical unrest? or perhaps the market believes that the world will suddenly consume much more oil than it did before the recession?

As a trader, we don’t really care whether there is a legitimate move or manipulated by deep pockets. But at the same time, if you’re going long and letting the trend take you for a ride, just remember the difference between turkeys that get caught up in a tornado and eagles. One comes down to earth with a thud. The other soars majestically, landing at a time and place of its choosing.

Here’s an interesting chart from Chart of the Day: the historical ratio between gold prices and the Dow Jones Industrial index.

Or in other words, how much gold would you need to buy the Dow?

In the early 1980’s, just before the mega-bull market was about to awaken, you only needed 1.5 ounces of gold. But at the top, in 1999, you needed almost 49 ounces of gold to afford the Dow.

Over time, the two don’t always move opposite each other but during the past few years, not only has the stock market fallen, but gold has gone up. That has resulted in an unwinding of the ratio.

While the Dow Jones Industrial has only fallen 25% from its 1999 top, priced in gold, it has fallen almost 80%. We’re back to the levels that we saw in the early 1990’s

But of course, this ratio is ignoring dividends which gold doesn’t pay but the Dow does pay. I wonder what the chart would look like with that taken into account. Probably very similar.

Whether we’re seeing the birth of a new bull market or not, this ratio is not convinced that stocks, relative to gold are really cheap. Or at least, as cheap as we’ve seen them. Keep in mind that while the market may at times rhyme, it rarely repeats itself.